Monday, April 11, 2011

Questions About the Euro Debt Crisis

I've been thinking a lot about Europe lately. In particular, the debt crisis among certain euro countries -- namely the PIIGS (Portugal, Ireland, Italy, Greece, Spain) -- has been on my mind. Here's the picture:

A few questions keep coming to my mind when I look at this picture and ponder the tremendous risk premia (defined as the spread over German bond yields) that have been applied to the sovereign debt of several euro countries over the past 2 years or so. Those questions include:

Does this experience fit with our understanding of financial contagion, such as from the currency crisis literature?

Are these risk premia the result of fears of default, devaluation (i.e. dropping the euro), or both?

Should we think about this as a currency crisis, a debt crisis, or both?

Why has the crisis hit the PIIGS, but not other euro countries?

Is Spain really vulnerable? Italy?

Where will it end?

Is austerity the right response?

How large does the bailout fund need to be, and will it work?

Can you think of any other significant questions about this subject that we don't already know the answers to?

I'm working on a theoretical framework that is helping me to think about some of these questions. I hope to share it with you soon. In the meantime, though, I have pulled together a bit of data with which to fuel the speculation...

I find it interesting to note that the initial stock of net government debt seems to have no bearing on whether a country was hit by the debt crisis - it's all about the government budget deficit in 2009 (and presumably 2010 as well, though Eurostat doesn't have 2010 budget deficit data up yet). It's also interesting to note that France had similar debt and deficit numbers as Portugal through 2009, yet has been one of the countries least affected by the debt crisis. Clearly political and financial considerations other than simple macroeconomics do matter here, and the financial ties between France and Germany are perceived to be such that a French default (or abandonment of the euro) is seen as extremely unlikely.

I know it might seem a bit unfair that I just put up a bunch of questions with no answers, but I'll be sure to get the definitive answers to you soon. (Yes, tongue is planted firmly in cheek.)

Contact

The Street Light is written by economist Kash Mansori, who works as an economic consultant (though views expressed here are entirely his own), writes whenever he can in his spare time, and teaches a bit here and there. You can contact him by writing to the gmail account streetlightblog. (More about Kash.)